Mad Cows, Terrorism and Junk Food: Should Public Policy Reflect Subjective or Objective Risks?

Abstract

Empirical evidence suggests that people’s risk-perceptions are often systematically biased. This paper develops a simple framework to analyse public policy when this is the case. Expected utility (well-being) is shown to depend on both objective and subjective risks. The latter are important because of the mental suffering associated with the risk and as a basis for corrective taxation and second-best adjustments. Optimality rules for public provision of riskreducing investments, “internality-correcting” taxation and provision of (costly information to reduce people’s risk-perception bias are presented.